How To Set Up Your Real Estate Contract For Maximum Safety and Value

Part 1 of 6 - Introduction

This series of articles deals with the safety and the value of your contract, and how you can set up the contract to maximize both.

Safety means how likely it is that the buyer will fully pay off the contract in full. One of two things will happen: either the buyer will make all the payments on the contract and eventually pay it off, or they will default and you’ll have to “foreclose”. Safety is figuring out how likely it is that the buyer will pay it off, or if things don’t go well, what you can expect to get back in a “foreclosure”.

Value means what you could expect to get in cash if you choose to sell your contract. One of the biggest mistakes people make when owner financing the sale of a property is assuming that they will never want to sell it. Designing a contract for value is “money in the bank” even if you never sell it.

There are three main reasons people owner finance the sale of their property. One reason is income, meaning the seller wants the long-term income of the monthly payments. Another reason is to defer the potential tax consequences (capital gain) of selling real estate. And finally, many people owner finance because it is difficult or impossible to obtain conventional financing for the property being sold, and owner financing is the best way to get a property sold. Old mobile homes, land, and commercial properties are examples of this type of property.

Regardless of why you owner financed the sale of your property, there is one thing for sure: You want the payments to come in on time every month until the contract is paid in full. Hundreds of investors have spent thousands of hours trying to create a “formula” to predict payment reliability. There is no magic formula for how reliable payments will be. The best you can do is to measure the potential risk of a deal, and set the terms of the contract to match.

The terms you offer to your buyer should reflect the risk you are taking. In the real estate industry, there are “rules of thumb” that float around, such as “The interest rate on a Real Estate Contract should be 1% above the current bank rates”. Nothing could be further from reality. The rule is: set the terms of the contract according to the risk you are taking. There is one rule that has few exceptions: If you sell a piece of property to someone with very low down payment who has bad credit, you’ll probably get the property back. If you have to “foreclose”, you should count on losing 15% or more of the value of the property due to cleanup costs, eviction costs, and property damage and repair costs. What terms could you possibly offer that would offset an almost certain loss?

The newsletters that follow will discuss in detail the terms and will offer you an opinion on how you can decide on terms (the terms are price, interest rate, balloon payments, payment amount, etc) that reflect the risk you are taking. You’ll get some techniques that can help shield you from some of the possible problems that you may encounter during the life of the contract.

Think about this first and foremost when you create your contract: Once you’ve signed the contract, you can never change its terms, and you can’t change the buyer. The value of the contract is almost completely determined by these factors.

Remember that what you read in these articles is the opinion of Capital Creations LLC and the many investors that we work with; we use these ideas and you can too. Or … you can ignore them. We’re not giving you advice. You should seek competent legal and/or tax professional help if you want advice!